Portfolio Allocations Using Fundamental Ratios: Are Profitability Measures Effective in Selecting Firms and Sectors?
Posted: 22 May 2019
Date Written: May 3, 2016
Our study assesses the performance of portfolios formed using out-of-sample sector forecasts and past firm fundamental ratios. Portfolio allocations based on profitability measures - gross profit, operating profit, and EBITDA - generate performance substantially better than the benchmark. Long/short portfolio allocations using these fundamentals possess alphas over 14% and increase Sharpe ratios by over 60%. A composite variable provides the highest payoff for firm allocations, while EBITDA produces the most profitable out-of-sample sector allocations. Profitability metrics are superior indicators of sustainable economic performance because these ratios are more strongly linked to future returns and cash flows than net income.
Keywords: Portfolio Allocation, Sector, Fundamentals, Gross Profit, Operating Profit
JEL Classification: G11, G12, G17
Suggested Citation: Suggested Citation